Monday, June 25, 2007

Interesting debate at the Wall StreetJournal about the reasons behind the recent jump in bond yields. (An issue discussed repeatedly in this blog). Both James Hamilton and Mark Zendi dismiss the inflation-expectations explanation, largely because "the inflation-protected TIPS yields are up just like the nominal." All right. Prof. Hamilton then presents the bullish case: higher demand for credit from the private sector fuelled the rise in yields. There is, however, a serious problem with the way the case is presented. Mr. Hamilton says his views were confirmed by the subsequent strong performance of the equity market. In other words: his hypothesis can only be confirmed/denied after the facts.

I strongly favor the more ex-ante spreads-based approach. It's a bit more risky, but it can be useful from a trading perspective. Now, it is becoming increasingly clear that something has changed since last week. Surging CDS spreads point to a contraction in the supply of loanable resources — a much more bearish proposition in terms of risky assets (Our Endogenous Liquidity Index is almost flat!). Here's Mark Zendi:

Behind the higher rates is slowly evaporating global liquidity. This is most evident in tighter monetary policies across much of the globe. Central banks ranging from the European Central Bank to the Chinese Central Bank are in the midst of a series of tightening moves ... I also believe, however, that next year as global liquidity continues to dry up, long-term rates will resume climbing. Equilibrium 10-year Treasury yields are closer to 6%. In other words, this is the rate that should prevail in the long-run abstracting from the vagaries of the business cycle and the effects of shifting global liquidity.

So where do we go from here? To become "officially" bearish, I want to see declines in both the Global Dollar Liquidity measure and in the Endogenous Liquidity Index. This is clearly not the case with the Global Dollar Liquidity measure. But will investors in the CDO market panic, sending credit spreads even higher? Take a look at this fascinanting piece about the so-called "CDO Put":

Basically, the CDO put, as I'm using it, refers to the fact that wider credit spreads result in making CDO creation easier. Thus a minor widening event will be met with increased CDO issuance, thus creating a back-stop to spreads.Increased CDO issuance! A back-stop to spreads! I agree with this fairly bullish view, if only because funding liquidity will need to be deployed. Credit spreads are likely to be the key "tell" going forward.